Public Information Notices (PINs) are issued, (i) at the request of a member country, following the conclusion of the Article IV consultation for countries seeking to make known the views of the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies of member countries by increasing the transparency of the IMF's assessment of these policies; and (ii) following policy discussions in the Executive Board at the decision of the Board. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2003 Article IV consultation with Eritrea is also available.

On May 2, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the 2003 Article IV consultation with Eritrea.1

Background

Eritrea is confronted with a wide range of serious economic challenges, including crisis management related to the drought and macroeconomic stabilization in the immediate term and the move toward a peacetime economy in support of growth and poverty reduction over the medium term. Addressing these challenges will require a combination of decisive crisis management, sound macroeconomic and development policies, and extensive donor support to lay the foundations for higher economic growth and poverty reduction over the medium term.

Among the immediate challenges, the most critical is the management of the worst drought since the country's independence which has reduced crop production to about a quarter of the average level observed over the past 10 years and threatens the lives of some 1.4 million Eritreans, about a third of the population. Donor response to the joint Eritrean and UN Consolidated Inter-Agency Appeal has been weak, and the authorities have had to take alternative action to prevent starvation, including external borrowing.

Macroeconomic performance has been seriously impaired by the drought and the lingering effects of the border conflict with Ethiopia during 1998-2000, which has resulted in large-scale destruction of infrastructure and dislocation of the population. The authorities have also remained concerned about the unresolved border issue and have only hesitatingly begun to implement the donor-supported demobilization program for some 200,000 combatants. Reflecting these factors, economic growth in 2002 was negative at -1.2 percent, against 8.7 percent in 2001. The weakness of the economy and tight supply situation resulted in a sharp acceleration of inflation, with consumer prices rising by 24 percent by end 2002, compared with 8 percent at end-2001.

Unsustainably large macroeconomic imbalances persisted in 2002 despite some reductions in the fiscal and external current account deficits. Because of substantially lower externally financed capital spending, fiscal policy turned out to be much less expansionary than foreseen under the approved budget. In the event, the overall fiscal deficit, including special programs and grants, amounted to some 30 percent of GDP, compared with 35 percent of GDP in 2001. As in previous years, covering the government deficit required a large increase in domestic monetary financing, which contributed to inflation and put additional pressure on the external balances, foreign reserves, and the exchange rate. The external current account deficit nevertheless declined to 15 ½ percent of GDP in 2002 from 18 ½ percent in 2001, owing mainly to an increase in private transfer receipts, exceptional gold sales by the central bank, and the shortage of foreign exchange for private transactions that curtailed imports. Official reserves of Eritrea dropped below one month of imports of goods and services in 2002.

For 2003, the authorities prepared an "austerity" draft budget intended to reduce the domestic fiscal deficit (excluding all foreign-financed spending) to some 6 ½ percent of GDP, compared with 21 percent in 2002. On the revenue side, large increases were expected from the sales of government-owned houses and apartments, as well as the privatization of 3 hotels. On the expenditure side, the principal savings were planned to come from the demobilization of 130,000 combatants, which would have cut the defense budget in half. Because measures on both the revenue and expenditure side may be more difficult and time-consuming to implement than initially believed, the staff now projects a domestic fiscal deficit of 13 ½ percent of GDP.

Monetary policy has in recent years been dominated by the financing needs of the government's sizeable fiscal deficits. Money supply increased by 26 ½ percent in 2001 and 18 ½ percent in 2002, with credit to the government as the driving force.

Because of the precarious international reserves position and the virtual fixing of the official exchange rate, a dual exchange rate system has emerged in which the differential between the official and parallel market rates has risen markedly. Under the system, official transactions and other priority needs are being conducted in the official market, while the vast majority of private transactions, including bona fide current transactions, are being channeled through the parallel market. While the official rate has been kept largely unchanged at some ERN 14 per U.S. dollar since September 2001, the rate in the parallel market has lately moved up to between ERN 22 and ERN 24 per U.S. dollar.

In order to promote economic recovery and reduce poverty, the authorities hope to press ahead with a swift demobilization of combatants which would relieve the severe shortages of labor especially in the private sector, including agriculture. In addition, the authorities plan to continue their investment in human capital to raise labor productivity and improve competitiveness, and to further advance the rehabilitation and expansion of economic and social infrastructure. They are also strengthening prudential regulation and supervision to promote a sound and healthy financial sector. Other structural reforms that would increase economic growth include policies to reduce the role of government in commercial activities and strengthen private sector development. The government will be improving the dissemination of information on economic policies to increase transparency and facilitate the dialogue with the private sector.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. They noted that macroeconomic conditions in Eritrea deteriorated in 2002—real GDP declined, inflation accelerated, and gross international reserves declined. In addition, the fiscal and external deficits remained unsustainably large. Directors acknowledged that these developments stemmed to a considerable extent from a serious drought, the legacy of war, political and governance difficulties, and limited human and financial resources. Nevertheless, they observed that there had been policy slippages as well, and stressed the need for urgent and decisive actions by the authorities to confront the enormous economic challenges facing Eritrea in the period ahead, including addressing the severe drought, accelerating the demobilization and re-integration of combatants, re-establishing macroeconomic stability, and laying the foundations for sustained economic growth and poverty reduction.

Against this background, Directors welcomed the important progress already made in some areas, including tax and expenditure reform, trade liberalization, and bank supervision. They called on the authorities to build on these efforts by formulating a comprehensive medium-term economic strategy. Such a strategy should be grounded in sound macroeconomic policies, properly prioritized and sequenced structural reforms, and a poverty reduction strategy formulated through a broad participatory approach. Directors recognized that external assistance will be critical for the success of the economic strategy, and encouraged the authorities to step up their efforts to resolve outstanding governance issues with donors to permit the resumption of such assistance. They urged the authorities to build the capacity needed for implementing a comprehensive reform program and supported the authorities' request for Fund technical assistance.

Directors welcomed the authorities' intention to substantially reduce the fiscal deficit in 2003, primarily through cuts in current spending, while shifting expenditures to education and health. While acknowledging that it will be difficult to achieve the deficit reduction, Directors urged the authorities to maintain the budget targets and to make best efforts to contain the domestic budget deficit at a level close to its initial target. This will require continued strengthening of expenditure control, improvement in revenue administration, and prompt promulgation of tax laws. Directors cautioned against lax public sector employment as a means of reducing unemployment among ex-combatants. Also, noting the rapid build-up of external public debt, Directors advised the authorities to develop a comprehensive debt strategy that relies mainly on concessional borrowing.

Directors observed that monetary and exchange rate policy had, over the past years, been entirely subordinated to the large financing needs of government. They called on the authorities to restore the effective independence of the central bank, and strengthen its transparency and accountability, so that it can concentrate on achieving the inflation and external balance objectives. They supported monetary tightening and a return to positive real interest rates. In addition, Directors urged the central bank to develop a coherent and transparent monetary policy framework that is better coordinated with fiscal policy, is supportive of the exchange rate regime to be put in place, and provides for a firm nominal anchor.

Directors expressed concern about the pervasiveness of exchange restrictions and distortions under the present dual exchange rate regime. They stressed the importance of unifying the official and parallel foreign exchange markets and introducing a single flexible exchange rate. The move toward such a regime should be supported by a phased removal of the existing exchange restrictions on current transactions.

While acknowledging that the government will continue to play an important role in the Eritrean economy, they urged the authorities to do a careful appraisal of that role and to adopt policies that foster the development of the private sector. They noted that dominance of publicly owned or managed enterprises could reduce competition and give rise to inefficiencies. They also called for the establishment of a sound and reliable legal and regulatory framework. Measures that could impede the expansion of the private sector, such as the recent official proclamations that tighten business licensing procedures and require the submission of business plans, should be reviewed.

Directors welcomed the strengthening of prudential regulation and supervision over the past two years. They noted that recent onsite inspections had revealed banking sector weaknesses, and urged that steps be taken to strengthen bank management and operations in line with best international practices. Directors also expressed concern about the high degree of concentration in the financial sector, and encouraged the authorities to consider steps to increase competition by actively promoting the entry of additional banks and privatizing dominant institutions. They welcomed the authorities' efforts to combat money laundering and terrorism financing.

Directors called for a broadening of the flow of information, an increase in transparency, and a strengthening of dialogue and cooperation mechanisms within government and between the government and the private sector. They urged the authorities to increase fiscal transparency through regular publication and open discussion of the budget, in order to encourage participatory policy formulation and increase accountability.

Directors noted the extensive weaknesses in statistics and urged the authorities to promulgate without delay a Statistical Act that was designed in order to strengthen statistical institutions and processes. They recommended regular publication of timely and reliable key statistics in the context of a strong and coherent reform agenda, supported by adequate financial and human resources. This would be crucial, inter alia, to permit proper assessment of the authorities' track record of policy implementation.

Directors welcomed the renewed interest of the authorities in a Fund-supported economic program. They encouraged the authorities to establish a solid track record of policy implementation under a staff-monitored program, with a view to establishing quickly—in collaboration with Fund staff—conditions permitting the negotiation of an arrangement under the Poverty Reduction and Growth Facility, and to advance speedily with the drafting of an Interim Poverty Reduction Strategy Paper.

It is expected that the next Article IV consultation with Eritrea will be held on the standard 12-month cycle.

1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.